Are commodity prices peaking?

By Kurt Brouwer

Commodity prices are currently surging. We have heard about oil prices and precious metals, but commodities are up broadly as the following charts show. The question I have in looking at them is this: Are prices peaking? First, a word on commodity indexes. There are different indexes we can use to look at commodities. Many use the Commodity Research Board (CRB) Index, but that can be misleading because the CRB is heavily-weighted to energy. A different way to look at commodities more broadly is the Continuous Commodity Index (CCI) because it does not overweight energy. The CCI covers a broad array of commodities, including precious metals, energy and much more.

Here is a link to the Thompson Reuters site if you want to learn more about the indexes. It describes CCI as follows [emphasis added]:

THE EQUAL WEIGHTED COMMODITY INDEX

CCI components are equally weighted and therefore distribute more evenly into the major sectors: Energy 17.65%, Metals 23.53%, Softs 29.41% and Agriculture 29.41%. While other commodity indices tend to have overweighting in certain sectors (e.g. Energy), the CCI provides more meaningful exposure to all four commodity subgroups.

The 17 components of the CCI are continuously rebalanced to maintain the equal weight of 5.88%…

This chart shows the components and the equal weighting such that each component has 5.88% of the index:

The first peak was in the summer of 2008 and then commodity prices fell sharply during the panic of 2008. The bottom was in December of 2008, shortly after the Fed announced the first round of quantitative easing. Since then, the trend has been up.

In an earlier post, Trader Dan described the recent mood swings in the CCI as follows [emphasis added]:

…Note the massive selloff in the CCI after it peaked in mid 2008 as the credit crisis erupted and the carry trade was unwound. That move towards risk aversion resulted in wholesale selling of commodities across the board.

By ‘carry trade’ he is referring to a trading strategy used by hedge funds, banks and Wall Street firms to borrow money in Japan at low interest rates to invest in other countries at higher rates. This trade became unprofitable during the financial panic. Trader Dan continues:

…the plunge in commodity prices did not stop until the Federal Reserve announced that it would soon commence a program known as Quantitative Easing. That had the immediate effect of launching a multi-year rally in commodity prices which took the index past the all time peak it had previously reached in the summer of 2008…

The Federal Reserve announced the first round of so-called quantitative easing back in November 2008. A few months later, in early 2009, it ramped the program up considerably and the rally in commodities (and in stocks too) ramped up. As you can see, the CCI has now gone well above the high point from 2008.

The second chart shows the CCI since 1993 and it puts this current price spike in a sobering context:

Commodities languished until late 2001 when the Fed dropped short-term interest rates in response to the attacks of September 11, 2001 and the short-lived recession later that year. Unfortunately, the Fed under then-Chairman Alan Greenspan held rates very low and the rest is…history. Commodities had been in a low trading range for years and a combination of easy money and low prices fueled the new commodities bull market.

The Fed giveth & the Fed may take away

The lesson here is pretty clear. The Fed giveth and the Fed can take away. What is likely to happen when the current version of quantitative easing (QE II) ends? Assuming the economy can continue growing — and I believe it can — then demand for commodities should remain fairly strong. However, have prices gone far beyond the boundaries of normal supply and demand due to QE and QE II? We will find out later this summer.

This does not mean commodity prices are going to plunge, nor does it mean the bull market is done. However, no matter how much you believe in the commodity bull market, I believe caution is in order because there is plenty of room on the downside.

About Fundmastery Blog

Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.